12 Suppose that the risk-free zero curve is flat at 1.3% per annum with continuous compounding and that defaults can occur at times 0.25 years, 0.75 years, 1.25 years, and 1.75 years in a two-year...

12

Suppose that the risk-free zero curve is flat at 1.3% per annum with continuous compounding and that defaults can occur at times 0.25 years, 0.75 years, 1.25 years, and 1.75 years in a two-year plain vanilla credit default swap with semi-annual payments. Suppose that the recovery rate is 40% and the unconditional probabilities of default (as seen at time zero) are 1% at times 0.25 years and 0.75 years, and 1.5% at times 1.25 years and 1.75 years. (i) Estimate the credit default swap (CDS) spread in the example above. (ii) Evaluate why CDS markets provide an important barometer of the creditworthiness of corporate bond markets.